Retirement Planning

Retirement Income Planning

Income Integration

A common question from a retiree is, “How do we best withdraw income from our investments?” This is a very important issue that needs careful consideration as the wrong strategy will result in the retiree paying too much in taxes and exhausting their life savings or having to reduce their lifestyle spending.

The strategy that is often recommended to retirees is the tax deferral method. This method results in deferring taxes as long as possible. This deferral allows the retiree to maximize the growth of their investments and maintain their nest egg longer.

The Tax Deferral Method

Many retirees have various sources of income, such as pension plans, their own RRSP's/RRIF's, spousal plans and non-registered accounts. By selecting the proper sequence to draw upon these accounts, a retiree can maximize their current after-tax income, and help to maintain their wealth as long as possible. The tax deferral method will not only provide the retirees with the largest nest egg for themselves, but also the largest taxable estate.

The process is to select the accounts that will produce the income required for the retiree at the lowest possible tax rate.

The Optimal Draw Down Sequence

The recommended sequence to withdraw retirement income follows.

Pension Income—The first source for retirement income would be any pension incomes such as employer pensions and government pensions including Canada Pension Plan (CPP) and Old Age Security (OAS).

Non-Registered Assets—if the pension incomes do not provide an adequate income source, the first assets to be redeemed are the non-registered assets that a retiree may own. The reason being is that the income taken is not all taxable, since part of the income is made up of the retiree’s own capital. The redemption order is based on the following:

►    Marginal Tax rate of Spouses - The optimal drawdown is based on each spouse’s current and future tax brackets. Normally, the assets withdrawn first are those of the spouse that has the lowest marginal tax rate, followed by the higher marginal tax rate spouse’s assets.

►    Order of the Investments/Assets –The sequence for non-registered assets is to first withdraw the highest ratio of cost base to market value. This is to reduce any capital gains taxes on the selling of assets to produce the income. To break any ties the rate of return is used, with the lower yielding assets being redeemed before higher yielding assets. This process is to defer capital gains for as long as possible.

Registered Assets—If the income available is still not enough, the next source of income is the registered assets. For retired couples, the normal order for withdrawing an income is:

►    The spouse with the lower marginal tax rate, followed by

►    The spouse with the higher marginal tax rate.

If there is a tie based on tax rates, the assets are redeemed in order of their total return from lowest to highest.

This entire process is used to forecast income and assets over the retiree’s lifetime and needs to be updated annually based on the most current spending requirements and tax situation.

Tax Allocation of Investments

Another important feature of this strategy is to place investments in the accounts so that they attract the least amount of taxes today. For example, this would mean that any fixed income type of investments, such as bonds or GICs should be placed in RRSP or RRIF accounts and the investments that generate the most tax effective gains such as equities or equity mutual funds should be placed in non-registered accounts.

Similar type of tax savings can also be accomplished in non-RRSP accounts, by having the spouse with the lower marginal tax rate own the interest income investments, and the higher income spouse owning the equities/equity mutual funds that generate tax preferred income such as capital gains.

The impact of other assets such as downsizing a house in the future, selling a cottage property or the expected costs of a long-term health care facility can be incorporated into the planning process. It is important that the process be customized to each retiree’s unique situation.

Conclusion

The most important part of retirement income planning is that it is a continuing process and not a one time event. Each year the income plan has to be updated to reflect any changes that may occur. The changes may include personal aspects such as changes in spending habits, health changes, special plans (i.e. trips) and investment aspects such as asset allocation re-balancing or a review of tax changes. A systematic review at the beginning of each year based on current goals and objectives will help the retiree feel more comfortable with their retirement income regardless of what happens in the stock market. 

The information contained in this commentary is designed to provide you with general information only, and is not intended to be comprehensive advice applicable to the circumstances of any individual. We strongly urge you to seek professional assistance before acting upon information included herein.